Finance: review of causes and management of the crisis

It is a great pleasure to speak to you today on the critical issue of financial sector regulation and the key policy requirements for stable financial conditions in Europe, especially in Central, Eastern and South-eastern European Economies (CESEE).

The causes of the crisis first

At the heart of the crisis are failures of financial regulation, of supervision, of risk management and of corporate governance. Not just in the United States, where the sparks were first lit, but also in other countries around the world, including here. Regulatory weaknesses created incentives for excessive risk-taking by financial institutions at a time of historically low interest rates. Lenient oversight by prudential regulators added to these problems.

The costs of the crisis have been enormous. GDP contracted by about 3.5% in the OECD area as a whole in 2009 and unemployment reached a post-war high of close to 9% on average. The longer-term legacy of the crisis is also heavy. Public debt in OECD countries is expected to be 100% of GDP at the end of the year, some 30 percentage points higher than before the crisis. OECD countries may have lost about 3% of potential output.

Decisive action by policymakers will be required to implement the reforms needed to restore long-term potential growth and put public finances back on a sustainable path.

Facing financial regulatory challenges: The mixed picture

Our starting point is that the financial system is nothing more than a system of commitments between interconnected players. These commitments should be treated in the same way no matter where they sit. So, how far have we gone in meeting this fundamental goal? The answer is that achievements so far have been mixed.

Let me share with you the OECD’s reflections.

1. Enhancing the global effort

The recent Basel III agreement to lift global minimum capital standards is an important step forward. It will help align capital rules and introduce dynamic provisioning and capital buffer concepts at an international level.

A staggered phasing-in period will allow the banking sector to adjust to the higher capital standards. In light of the fact that starting points in capital levels differ across countries, a stepwise timetable seems appropriate. Europe, for example, has less bank capital than the US for historical reasons, and its corporate sector is comparatively more dependent on bank finance. A degree of gradualism is therefore necessary over the coming years to accompany the capital building process, while still supporting lending to the economy.

The progress to mainstream the global playing field remains, by contrast, still very uneven. Harmonisation is essential to eliminate regulatory arbitrage. The need to achieve transparent and comparable accounting rules is particularly urgent. Under present rules balance sheet concepts are not comparable and a clear timeline towards full harmonisation is not yet in sight.

2. Unequal regional progress

As it happens, regional elements of differentiation are also important.

In June this year, the United States launched a landmark financial sector reform. The final act contains key elements that the OECD welcomes because they pave the way for better coordination of regulators. It establishes a Financial Stability Oversight Council; a consumer protection agency (also proposed by the incoming UK government); and it looks to better co-ordinate insurance regulation.

Separation of some risky (investment) bank activities from (more traditional) lending activities and to better regulate derivatives is also a landmark. While not the full firewall approach that the OECD has been advocating, it compares very favourably with Europe where separation issues are not being considered at all.

Moreover, regulators are given resolution authority to seize and break up troubled financial firms that might cause systemic damage. Some problems in the mortgage market at the origin of the crisis have also been addressed. Yet, a comprehensive mortgage market reform remains warranted -- including a solution for Fannie Mae and Freddie Mac.

Hopefully, the Dodd-Frank Act has firmly thrown down the challenge to Europe to carry out its own reforms. We do think that Europe needs reforms not just to bring regulations into better cross-border alignment within the region, but also as an essential contribution to financial harmonisation at the global level. What we have seen so far is that Europe has moved more strongly in regulating credit rating agencies and alternative investors such as hedge funds and private equity firms. Philosophically, the US has a much “lighter touch” approach to these issues.

Somewhat encouraging is that in some areas US and EU policy responses are similar. Some examples:

Europe, too, is looking for better co-ordination of regulation with respect to macro-financial stability with its Systemic Risk Council located at the ECB.

Both the US and the EU aim to channel as much trading of derivatives as possible to centralised clearing and onto exchanges.

Furthermore, both EU and US banks will be required to retain some ‘skin in the game’ by keeping a minimum share of 5 per cent of securitisations on their balance sheets, rather than transferring them completely to investors. This will encourage better risk assessments.

Let me turn briefly to the specific reform needs of the CESEE. Although these countries were generally less exposed to toxic assets than elsewhere, borrowing by the household sector did expand very quickly.

A number of common policy issues do stand out:

First, consumer protection and underwriting standards issues have emerged in a number of countries, particularly in Hungary and the Slovak Republic. Fostering financial education, complemented by improved consumer protection, will be important to address these issues, particularly the role of foreign currency borrowing. The OECD is a forerunner in financial literacy and the related standard setting dialogue. We are ready to support policy makers in this field.

Second, foreign institutions play a prominent role in the financial sectors of the region. This has bought benefits, including the inflow of foreign capital investment and the transfer of expertise. However, it has also implied new challenges including regulatory arbitrage, branch/subsidiary structures, cross-border capital flows and parent-to-subsidiary contagion. These are challenges that multilateral co-operation and co-ordination can help to address. The recently established Nordic-Baltic Cross-Border Stability Group serves as a good example.

Finally, CESEE countries need to improve the efficiency of their financial sectors. This is another key policy area the OECD has been working on with its Central and Eastern European member countries.

To conclude, the outcomes of the recent efforts to reform the global financial sector depict a scattered picture. Further global and regional improvements in the structure and oversight of the financial sector should be achieved to ensure that the benefits of financial intermediation are shared widely, ultimately supporting stable economic growth. In the tradition of the OECD work method, we recognise that challenges can differ, as well as the ways to respond to them. Yet, the principle of sound regulation should in no way be compromised. The OECD is committed to continue working with governments in shaping policies and solutions to stick to this fundamental principle.

I very much look forward to having a rich and lively discussion with you all.